An editorial blog of CFA Society Minnesota

One of my joys is beekeeping. In fact, I have learned a great deal about human investing behavior from observing bee behavior. For example many people believe that bees hop from one flower to the next, be it a dandelion, snap dragon, petunia, or whatever flower happens to be around. Actually bees are very particular about what flowers they visit. They usually focus solely on what is blooming in force at the moment such as a grove of apple trees or a large field of clover. Investors, for better or worse, are very similar—“the swarm” congregates to whatever is currently blooming in the market.

Investment styles come in and out of season, much like flowers. Most investors focus on the business cycle—certain sectors work at certain times in the cycle. We believe this is true, but we also think that we can break it down even further. Since most of us have a financial background, often times how investors focus attention on certain financial statements (i.e. income, cash flow and balance sheet statements) can work better as a guide to collective investor sentiment than analyzing individual sectors.

For instance when we are in the middle of a market upturn, investors often focus on income statements as they struggle to ascertain what to pay for future growth. Cash flow and balance sheets in this phase may not tell the whole story in the short-term as increased leverage and lower cash flows as companies increase sales forces, capacity, head count and other expenses associated with potential growth. Therefore accurately forecasting revenues on the income statement in this phase may be the most crucial task especially if investors believe that operating leverage on the income statement follows.

As the market matures and goes into a downturn, usually this is when we see cash flow statements take center stage. Investors may become preoccupied with the sustainability of results. More predictable free cash flows mean more potential earnings streams, more cash flows to shareholders and likely a less volatile stock. Additionally the ability to deleverage with free cash flows not only strengthens the financial outlook of the company; it also should give it a better ability to refinance debt as often interest rates decline at this phase of the cycle.

Finally as the market bottoms, this is often when balance sheets get their love. This is when investors focus on inventory levels, working capital management, debt ratios, potential goodwill write-downs and the like to determine how well the company is positioned to come out of a downturn financially. If the company has a strong balance sheet, it should have the ability to be more nimble than its peers to make timely growth investments in the future.

Therefore we likely can learn a lesson from our furry black and yellow friends. Don’t look at what individual bees are doing (although they are fun to watch). If one wants to determine which direction the market is going, watch the swarm. It may tell you where the cycle is if “the buzz” is focusing on one particular financial statement.